CHAPTER 12

Week 8 Class Exercises

1. Rhinestone National Bank reports the following figures in its current Report of
Condition:

Assets (millions) Liabilities and Equity (millions)

Cash and interbank $50 Core deposits $50
deposits
Short-term security 15 Large negotiable CDs 150
investments
Total loans, gross 400 Deposits placed by brokers 65
Long-term securities 150 Other deposits 45
Other assets 10 Money market liabilities 195
Other liabilities 65
Equity capital 55
Total assets $625 Total liabilities and equity capital $625

a. Evaluate the funding mix of deposits and nondeposit sources of funds employed by
Rhinestone. Given the mix of its assets, do you see any potential problems? What changes would
you like to see management of this bank make? Why?

Core deposits/Assets = 8.00 percent

Large Negotiable CDs/Assets
Deposits placed by Brokers/Assets
Other Deposits/Assets
Money Market Liabilities/Assets
Other Liabilities/Assets
Equity Capital/Assets
= 24.00 percent
= 10.40 percent
= 7.20 percent
= 31.20 percent
= 10.40 percent
= 8.80 percent

The proportion of core deposits at Rhinestone is exceptionally low, while large CDs and other
money-market borrowings make up more than 55 percent of the bank’s total funding sources.
This funding mix tends to subject the bank to excessive vulnerability to quick withdrawal of
funds and high interest-rate risk exposure. Rhinestone also appears to be excessively dependent
on brokered deposits which are highly volatile and interest-sensitive. Adding in these brokered
deposits, more than half of Rhinestone’s assets are funded with highly interest-sensitive deposits
and money-market borrowings. Management needs to expand the bank’s core deposits and other
more stable funds sources having less sensitive interest rates.

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b. Suppose market interest rates are projected to rise significantly. Does Rhinestone appear to
face significant losses due to liquidity risk? Due to interest rate risk? Please be as specific as
possible.

If interest rates rise, Rhinestone will experience higher interest costs immediately or within hours
or a few days on at least 50 percent of its funding sources. Unfortunately, all but $65 million of
its $625 million in total assets are longer-term, inflexible assets whose interest yields cannot be
adjusted as rapidly as the interest rates to be paid out on the bank’s liabilities. Other factors held
equal, the bank’s earnings will be squeezed. Management needs to do some serious restructuring
work on both sides of the bank’s balance sheet in moving toward more flexible-return assets and
more flexible-cost liabilities, and to move toward greater use of interest-rate hedging techniques.

2. Fine-Tuned Savings Association finds that it can attract the following amounts of
deposits if it offers new depositors and those rolling over their maturing CDs at the interest rates
indicated below:

Expected Volume of New Rate of Interest Offered

Deposits Depositors
$10 million 2.00%
15 million 2.25
20 million 2.50
24 million 2.75
26 million 3.00

Management anticipates being able to invest any new deposits raised in loans yielding 5.50
percent. How far should this thrift institution go in raising its deposit interest rate in order to
maximize total profits (excluding interest costs)?

Rate Exp. Diff.

Total Marginal Marginal Total
Expected Offered Marginal In Marg.
Interest Interest Revenue Profits
Inflows on New Cost Rate Rev and
Cost Cost Rate Earned
Funds Cost
$10 2.00% 0.2000 0.2000 2.00% 5.50% +3.50% $0.3500
$15 2.25% 0.3375 0.1375 2.75% 5.50% +2.75% $0.4875
$20 2.50% 0.5000 0.1625 3.25% 5.50% +2.25% $0.6000
$24 2.75% 0.6600 0.1600 4.00% 5.50% +1.50% $0.6600
$26 3.00% 0.7800 0.1200 6.00% 5.50% −0.50% $0.6500

Fine-Tuned Savings Association should raise its deposit rate to 2.75 percent, attracting $24
million in new deposits; because up to that point the marginal revenue rate is greater than the
marginal cost rate and total profits are also rising. At 3.0 percent, the marginal cost rate is greater
than the marginal revenue rate and total profits fall from a high of $0.66 million back down to
$0.65 million.

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3. New Day Bank plans to launch a new deposit campaign next week in hopes of bringing
in from $100 million to $600 million in new deposit money, which it expects to invest at a 4.25
percent yield. Management believes that an offer rate on new deposits of 2 percent would attract
$100 million in new deposits and rollover funds. To attract $200 million, the bank would
probably be forced to offer 2.25 percent. New Day’s forecast suggests that $300 million might be
available at 2.50 percent, $400 million at 2.75 percent, $500 million at 3.00 percent, and $600
million at 3.25 percent. What volume of deposits should the institution try to attract to ensure
that marginal cost does not exceed marginal revenue?

Expected Rate Total Marginal Marginal Marginal Exp. Diff. Total

Inflows Offered Interest Interest Cost Rate Revenue In Marg. Profits
on New Cost Cost Rate Rev and Earned
Funds Costs
$100 2.00% 2.00 2.00 2.00% 4.25% +2.25% $2.25
$200 2.25% 4.50 2.50 2.50% 4.25% +1.75% $4.00
$300 2.50% 7.50 3.00 3.00% 4.25% +1.25% $5.25
$400 2.75% 11.00 3.50 3.50% 4.25% +0.75% $6.00
$500 3.00% 15.00 4.00 4.00% 4.25% +0.25% $6.25
$600 3.25% 19.50 4.50 4.50% 4.25% −0.25% $6.00

The marginal revenue rate is greater than the marginal cost rate up to $500 million in new
deposits. At $600 million, the marginal cost rate of 4.50 percent is greater than the marginal
revenue rate of 4.25 percent. Therefore, New Day Bank should try and attract $500 million in
new deposits.

4. The National Bank of Mayville quotes an APY of 2.75 percent on a one-year money
market CD sold to one of the small businesses in town. The firm posted a balance of $2,500 for
the first 90 days of the year, $3,000 over the next 180 days, and $3,700 for the remainder of the
year. How much in total interest earnings did this small business customer receive for the year?

Using the APY formula we can fill in the variables whose values are known and find the
unknown interest earnings. Thus:

 Days in period  
 365 
  Interest earned
APY = 100  1 +  -1
 Average account balance  
 

  365 365 
Interest earned 
2.75 percent = 100  1 +  - 1
 Average account balance  
 

Where the account's average balance is found from:

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Average Balance 
 $2,500  90 days + $3,000  180 days + $3,700  95 days 
365 days

= $3,058.904

Then:

  365 365 
Interest earned 
2.75 percent = 100 × 1 + - 1
 $3,058.904  
 

Interest earned = $84.12.

5. Describe the essential differences between the following deposit pricing methods in use
today: cost-plus pricing, conditional pricing, and relationship pricing.

Cost-plus deposit pricing encourages banks to determine what costs they are incurring in labor
and management time, materials, etc., in offering each deposit service. Cost-plus pricing
generally calls for a bank to charge deposit service fees adequate to cover all the costs of offering
the service plus a small margin for profit.

Conditional pricing is used today as a tool by banks to attract the kinds of depositors they want to
have as customers. With this pricing technique a bank will post a schedule of offered interest
rates or fees assessed for deposits of varying sizes and based on account activity. Generally
larger volume deposits carry higher interest returns to the depositor or are assessed lower service
charges, encouraging customers to hold a high average deposit balance which gives the bank
more funds to invest in earning assets.

Finally, relationship pricing involves basing fees charged to a customer on the number of
services and the intensity of use of services the customer purchases from a bank.

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